© 2010 Pearson Addison-Wesley CHAPTER 1

© 2010 Pearson Addison-Wesley

Decision Time Frames The firm makes many decisions to achieve its main objective: profit maximization. Some decisions are critical to the survival of the firm. Some decisions are irreversible (or very costly to reverse). Other decisions are easily reversed and are less critical to the survival of the firm, but still influence profit. All decisions can be placed in two time frames:  The short run  The long run

© 2010 Pearson Addison-Wesley The Short Run The short run is a time frame in which the quantity of one or more resources used in production is fixed. For most firms, the capital, called the firm’s plant, is fixed in the short run. Other resources used by the firm (such as labor, raw materials, and energy) can be changed in the short run. Short-run decisions are easily reversed. Decision Time Frames

© 2010 Pearson Addison-Wesley The Long Run The long run is a time frame in which the quantities of all resources—including the plant size—can be varied. Long-run decisions are not easily reversed. A sunk cost is a cost incurred by the firm and cannot be changed. If a firm’s plant has no resale value, the amount paid for it is a sunk cost. Sunk costs are irrelevant to a firm’s current decisions. Decision Time Frames

© 2010 Pearson Addison-Wesley Short-Run Technology Constraint To increase output in the short run, a firm must increase the amount of labor employed. Three concepts describe the relationship between output and the quantity of labor employed: 1. Total product 2. Marginal product 3. Average product

© 2010 Pearson Addison-Wesley Product Schedules Total product is the total output produced in a given period. The marginal product of labor is the change in total product that results from a one-unit increase in the quantity of labor employed, with all other inputs remaining the same. The average product of labor is equal to total product divided by the quantity of labor employed. Short-Run Technology Constraint

© 2010 Pearson Addison-Wesley Table 11.1 shows a firm’s product schedules. As the quantity of labor employed increases:  Total product increases.  Marginal product increases initially but eventually decreases.  Average product increases initially but eventually decreases. Short-Run Technology Constraint

© 2010 Pearson Addison-Wesley Product Curves Product curves are graphs of the three product concepts that show how total product, marginal product, and average product change as the quantity of labor employed changes. Short-Run Technology Constraint

© 2010 Pearson Addison-Wesley Total Product Curve Figure 11.1 shows a total product curve. The total product curve shows how total product changes with the quantity of labor employed. Short-Run Technology Constraint

© 2010 Pearson Addison-Wesley The total product curve is similar to the PPF. It separates attainable output levels from unattainable output levels in the short run. Short-Run Technology Constraint

© 2010 Pearson Addison-Wesley Marginal Product Curve Figure 11.2 shows the marginal product of labor curve and how the marginal product curve relates to the total product curve. The first worker hired produces 4 units of output. Short-Run Technology Constraint

© 2010 Pearson Addison-Wesley The second worker hired produces 6 units of output and total product becomes 10 units. The third worker hired produces 3 units of output and total product becomes 13 units. And so on. Short-Run Technology Constraint

© 2010 Pearson Addison-Wesley The height of each bar measures the marginal product of labor. For example, when labor increases from 2 to 3, total product increases from 10 to 13, so the marginal product of the third worker is 3 units of output. Short-Run Technology Constraint

© 2010 Pearson Addison-Wesley To make a graph of the marginal product of labor, we can stack the bars in the previous graph side by side. The marginal product of labor curve passes through the mid-points of these bars. Short-Run Technology Constraint

© 2010 Pearson Addison-Wesley Almost all production processes are like the one shown here and have:  Increasing marginal returns initially  Diminishing marginal returns eventually Short-Run Technology Constraint

© 2010 Pearson Addison-Wesley Increasing Marginal Returns Initially When the marginal product of a worker exceeds the marginal product of the previous worker, the marginal product of labor increases and the firm experiences increasing marginal returns. Short-Run Technology Constraint

© 2010 Pearson Addison-Wesley Diminishing Marginal Returns Eventually When the marginal product of a worker is less than the marginal product of the previous worker, the marginal product of labor decreases. The firm experiences diminishing marginal returns. Short-Run Technology Constraint

© 2010 Pearson Addison-Wesley Increasing marginal returns arise from increased specialization and division of labor. Diminishing marginal returns arises from the fact that employing additional units of labor means each worker has less access to capital and less space in which to work. Diminishing marginal returns are so pervasive that they are elevated to the status of a “law.” The law of diminishing returns states that: As a firm uses more of a variable input with a given quantity of fixed inputs, the marginal product of the variable input eventually diminishes. Short-Run Technology Constraint

© 2010 Pearson Addison-Wesley Average Product Curve Figure 11.3 shows the average product curve and its relationship with the marginal product curve. When marginal product exceeds average product, average product increases. Short-Run Technology Constraint

© 2010 Pearson Addison-Wesley When marginal product is below average product, average product decreases. When marginal product equals average product, average product is at its maximum. Short-Run Technology Constraint

© 2010 Pearson Addison-Wesley Short-Run Cost To produce more output in the short run, the firm must employ more labor, which means that it must increase its costs. We describe the way a firm’s costs change as total product changes by using three cost concepts and three types of cost curve:  Total cost  Marginal cost  Average cost

© 2010 Pearson Addison-Wesley Total Cost A firm’s total cost (TC) is the cost of all resources used. Total fixed cost (TFC) is the cost of the firm’s fixed inputs. Fixed costs do not change with output. Total variable cost (TVC) is the cost of the firm’s variable inputs. Variable costs do change with output. Total cost equals total fixed cost plus total variable cost. That is: TC = TFC + TVC Short-Run Cost

© 2010 Pearson Addison-Wesley Figure 11.4 shows a firm’s total cost curves. Total fixed cost is the same at each output level. Total variable cost increases as output increases. Total cost, which is the sum of TFC and TVC also increases as output increases. Short-Run Cost

© 2010 Pearson Addison-Wesley The total variable cost curve gets its shape from the total product curve. Notice that the TP curve becomes steeper at low output levels and then less steep at high output levels. In contrast, the TVC curve becomes less steep at low output levels and steeper at high output levels. Short-Run Cost

© 2010 Pearson Addison-Wesley To see the relationship between the TVC curve and the TP curve, lets look again at the TP curve. But let us add a second x- axis to measure total variable cost. 1 worker costs $25; 2 workers cost $50: and so on, so the two x-axes line up. Short-Run Cost

© 2010 Pearson Addison-Wesley We can replace the quantity of labor on the x-axis with total variable cost. When we do that, we must change the name of the curve. It is now the TVC curve. But it is graphed with cost on the x-axis and output on the y-axis. Short-Run Cost

© 2010 Pearson Addison-Wesley Redraw the graph with cost on the y-axis and output on the x-axis, and you’ve got the TVC curve drawn the usual way. Put the TFC curve back in the figure, and add TFC to TVC, and you’ve got the TC curve. Short-Run Cost

© 2010 Pearson Addison-Wesley Marginal Cost Marginal cost (MC) is the increase in total cost that results from a one-unit increase in total product. Over the output range with increasing marginal returns, marginal cost falls as output increases. Over the output range with diminishing marginal returns, marginal cost rises as output increases. Short-Run Cost

© 2010 Pearson Addison-Wesley Average Cost Average cost measures can be derived from each of the total cost measures: Average fixed cost (AFC) is total fixed cost per unit of output. Average variable cost (AVC) is total variable cost per unit of output. Average total cost (ATC) is total cost per unit of output. ATC = AFC + AVC. Short-Run Cost

© 2010 Pearson Addison-Wesley Figure 11.5 shows the MC, AFC, AVC, and ATC curves. The AFC curve shows that average fixed cost falls as output increases. The AVC curve is U-shaped. As output increases, average variable cost falls to a minimum and then increases. Short-Run Cost

© 2010 Pearson Addison-Wesley The ATC curve is also U-shaped. The MC curve is very special. The outputs over which AVC is falling, MC is below AVC. The outputs over which AVC is rising, MC is above AVC. The output at which AVC is at the minimum, MC equals AVC. Short-Run Cost

© 2010 Pearson Addison-Wesley Similarly, the outputs over which ATC is falling, MC is below ATC. The outputs over which ATC is rising, MC is above ATC. At the minimum ATC, MC equals ATC. Short-Run Cost

© 2010 Pearson Addison-Wesley Why the Average Total Cost Curve Is U-Shaped The AVC curve is U-shaped because: Initially, marginal product exceeds average product, which brings rising average product and falling AVC. Eventually, marginal product falls below average product, which brings falling average product and rising AVC. The ATC curve is U-shaped for the same reasons. In addition, ATC falls at low output levels because AFC is falling steeply. Short-Run Cost

© 2010 Pearson Addison-Wesley Cost Curves and Product Curves The shapes of a firm’s cost curves are determined by the technology it uses:  MC is at its minimum at the same output level at which marginal product is at its maximum.  When marginal product is rising, marginal cost is falling.  AVC is at its minimum at the same output level at which average product is at its maximum.  When average product is rising, average variable cost is falling. Short-Run Cost

© 2010 Pearson Addison-Wesley Figure 11.6 shows these relationships. Short-Run Cost

© 2010 Pearson Addison-Wesley Shifts in Cost Curves The position of a firm’s cost curves depend on two factors:  Technology  Prices of factors of production Short-Run Cost

© 2010 Pearson Addison-Wesley Technology Technological change influences both the productivity curves and the cost curves. An increase in productivity shifts the average and marginal product curves upward and the average and marginal cost curves downward. If a technological advance brings more capital and less labor into use, fixed costs increase and variable costs decrease. In this case, average total cost increases at low output levels and decreases at high output levels. Short-Run Cost

© 2010 Pearson Addison-Wesley Prices of Factors of Production An increase in the price of a factor of production increases costs and shifts the cost curves. An increase in a fixed cost shifts the total cost (TC ) and average total cost (ATC ) curves upward but does not shift the marginal cost (MC ) curve. An increase in a variable cost shifts the total cost (TC ), average total cost (ATC ), and marginal cost (MC ) curves upward. Short-Run Cost

© 2010 Pearson Addison-Wesley Long-Run Cost In the long run, all inputs are variable and all costs are variable. The Production Function The behavior of long-run cost depends upon the firm’s production function. The firm’s production function is the relationship between the maximum output attainable and the quantities of both capital and labor.

© 2010 Pearson Addison-Wesley Long-Run Cost Table 11.3 shows a firm’s production function. As the size of the plant increases, the output that a given quantity of labor can produce increases. But as the quantity of labor increases, diminishing returns occur for each plant.

© 2010 Pearson Addison-Wesley Diminishing Marginal Product of Capital The marginal product of capital is the increase in output resulting from a one-unit increase in the amount of capital employed, holding constant the amount of labor employed. A firm’s production function exhibits diminishing marginal returns to labor (for a given plant) as well as diminishing marginal returns to capital (for a quantity of labor). For each plant, diminishing marginal product of labor creates a set of short run, U-shaped costs curves for MC, AVC, and ATC. Long-Run Cost

© 2010 Pearson Addison-Wesley Short-Run Cost and Long-Run Cost The average cost of producing a given output varies and depends on the firm’s plant. The larger the plant, the greater is the output at which ATC is at a minimum. The firm has 4 different plants: 1, 2, 3, or 4 knitting machines. Each plant has a short-run ATC curve. The firm can compare the ATC for each output at different plants. Long-Run Cost

© 2010 Pearson Addison-Wesley ATC 1 is the ATC curve for a plant with 1 knitting machine. Long-Run Cost

© 2010 Pearson Addison-Wesley ATC 2 is the ATC curve for a plant with 2 knitting machines. Long-Run Cost

© 2010 Pearson Addison-Wesley ATC 3 is the ATC curve for a plant with 3 knitting machines. Long-Run Cost

© 2010 Pearson Addison-Wesley ATC 4 is the ATC curve for a plant with 4 knitting machines. Long-Run Cost

© 2010 Pearson Addison-Wesley The long-run average cost curve is made up from the lowest ATC for each output level. So, we want to decide which plant has the lowest cost for producing each output level. Let’s find the least-cost way of producing a given output level. Suppose that the firm wants to produce 13 sweaters a day. Long-Run Cost

© 2010 Pearson Addison-Wesley 13 sweaters a day cost $7.69 each on ATC 1. Long-Run Cost

© 2010 Pearson Addison-Wesley 13 sweaters a day cost $6.80 each on ATC 2. Long-Run Cost

© 2010 Pearson Addison-Wesley 13 sweaters a day cost $7.69 each on ATC 3. Long-Run Cost

© 2010 Pearson Addison-Wesley 13 sweaters a day cost $9.50 each on ATC 4. Long-Run Cost

© 2010 Pearson Addison-Wesley 13 sweaters a day cost $6.80 each on ATC 2. The least-cost way of producing 13 sweaters a day. Long-Run Cost

© 2010 Pearson Addison-Wesley Long-Run Average Cost Curve The long-run average cost curve is the relationship between the lowest attainable average total cost and output when both the plant and labor are varied. The long-run average cost curve is a planning curve that tells the firm the plant that minimizes the cost of producing a given output range. Once the firm has chosen its plant, the firm incurs the costs that correspond to the ATC curve for that plant. Long-Run Cost

© 2010 Pearson Addison-Wesley Figure 11.8 illustrates the long-run average cost (LRAC) curve. Long-Run Cost

© 2010 Pearson Addison-Wesley Economies and Diseconomies of Scale Economies of scale are features of a firm’s technology that lead to falling long-run average cost as output increases. Diseconomies of scale are features of a firm’s technology that lead to rising long-run average cost as output increases. Constant returns to scale are features of a firm’s technology that lead to constant long-run average cost as output increases. Long-Run Cost

© 2010 Pearson Addison-Wesley Figure 11.8 illustrates economies and diseconomies of scale. Long-Run Cost

© 2010 Pearson Addison-Wesley Minimum Efficient Scale A firm experiences economies of scale up to some output level. Beyond that output level, it moves into constant returns to scale or diseconomies of scale. Minimum efficient scale is the smallest quantity of output at which the long-run average cost reaches its lowest level. If the long-run average cost curve is U-shaped, the minimum point identifies the minimum efficient scale output level. Long-Run Cost